I. Fiscal Management of Hydrocarbon Revenues1
Algeria faces important macroeconomic policy challenges with respect to the management of its natural resource wealth. The paper provides an overview of the issues relevant to prudent fiscal management of hydrocarbon revenues. It discusses alternative fiscal guidelines both for short-term and long-term policy formulation, and presents simulations for the sustainable long-run use of hydrocarbon revenues in Algeria under alternative scenarios, using a permanent income framework. Equally important is the question of how to make best use of the country’s hydrocarbon wealth to tackle the pressing tasks of attaining higher growth and reducing unemployment.
1. After a decade of civil strife and economic difficulties, Algeria has recently been experiencing a renewed growth performance, in large part aided by the strong development of the hydrocarbon sector since 1999. The hydrocarbon sector dominates the Algerian economy, accounting for 36 percent of GDP, almost 70 percent of fiscal revenue, and 98 percent of export receipts in 2003. Past efforts to diversify the economy by building up an import-substituting heavy industrial base during the period of centralized economic planning largely have failed.
2. The dominance of the hydrocarbon sector has been an important element in shaping the structure and management of the Algerian economy (Nashashibi et al. 1998). It weakened the incentives to develop the production of tradable goods outside the hydrocarbon sector. It distorted the tax structure through neglecting alternative revenue sources. Finally, it lead to an unstable fiscal policy stance that transmitted the volatility of international oil prices into the domestic nonhydrocarbon sector, thereby distorting factor allocation and hurting private sector investment and growth. The budget’s dependence on volatile hydrocarbon revenues also created a significant deficit bias by ratcheting up fiscal expenditures. Favorable oil prices were regularly seen as permanent increases in revenue and were followed by expenditure increases, which were difficult to reverse when the oil revenue increases proved to be only temporary.
3. Natural resource-based economies like Algeria face several macroeconomic policy challenges both in the short and long term. In a short- to medium term perspective, fiscal policy has to deal with high volatility of hydrocarbon revenues due to frequent and unpredictable price fluctuations, as well as with the impact of substantial foreign exchange inflows in the context of limited absorptive capacity of the domestic economy. In the long term, policymakers have to consider the exhaustibility of hydrocarbon resources and uncertainty of hydrocarbon wealth in connection with intergenerational equity and fiscal sustainability considerations.
4. In the case of Algeria, these fiscal policy challenges have to be evaluated in the context of the need to reduce the very high unemployment, to diversify the economic base, and to achieve a high rate of economic growth. In a situation of high unemployment, and with the society still recovering from a period of political instability and civil strive, policy makers have to weigh the medium- to long-term benefits of a prudent fiscal stance against the immediate needs of a fragile economy and social demands. However, Algeria’s history has shown that neglecting the fiscal policy challenges has not served the economy well. Unproductive and volatile spending has created allocative inefficiencies, economic disincentives, uncertainty in the private sector, and unviable state-run industries. Policy makers should take into consideration the specific characteristics of Algeria’s natural resource-based economy. A well thought-out and far-sighted fiscal policy could contribute to economic stability and growth, including the development of the nonhydrocarbon economy and the creation of employment opportunities.
5. The paper provides an overview of some of the issues relevant to prudent fiscal management of hydrocarbon revenues, such as the main macroeconomic policy challenges, the role of fiscal rules, and the alternative uses of hydrocarbon revenues. It discusses alternative fiscal guidelines both for short-term and long-term policy formulation, and presents simulations for the sustainable long-run use of hydrocarbon revenues in Algeria under alternative scenarios, using a permanent income framework.
6. The remainder of the paper is organized as follows: Section B portrays the most relevant aspects of the Algerian hydrocarbon sector and its relation to the government budget. Section C discusses the main macroeconomic policy challenges policymakers face in a hydrocarbon-based economy. Section D deals with the issue of long-term wealth preservation and introduces the permanent income framework. Alternative uses of saved hydrocarbon revenues are discussed in Section E. Section F presents some short- and medium term stabilization considerations, together with the most relevant indicators of the fiscal stance and respective fiscal guidelines. Simulations of the sustainable long-run path of the primary nonhydrocarbon balance in Algeria are carried out in Section G, while illustrative scenarios to bridge the gap between the current fiscal stance and a long-term sustainable one are presented in Section H. The concluding Section I summarizes the main results and policy recommendations.
B. The Algerian Hydrocarbon Sector
7. Algeria has a sizable hydrocarbon industry with a well-diversified product portfolio. The development of the Algerian hydrocarbon sector commenced in 1958 after the discovery of two giant oil and gas fields at Hassi-Messaoud and Hassi R’Mel in the Northern Sahara region. Crude oil production was at the centre of the expansion of the hydrocarbon sector during the 1960s and 1970s, even though natural gas extraction started already in 1961. Algeria became the world’s first Liquefied Natural Gas (LNG) producer in 1964, and refinery capacity expanded during the 1970s. The production and export shares of crude oil declined rapidly at the beginning of the 1980s, as oil production became increasingly constrained by OPEC quotas,2 some oil fields were gradually depleted, and secondary recoveries remained inadequate. Between 1980 and 1982, the export share of crude oil dropped from almost 80 percent to under 30 percent, while the export share of refined petroleum products, condensates, and LNG tripled. The diversification of the hydrocarbon product mix evolved further, when dry gas and LPG exports gained importance in the mid-1980s. Total gas production and exports more than doubled during this time as a result of the further development of gas liquefaction and pipeline capacity.
8. From independence in 1962 to the mid-1980s, Algeria followed a policy of economic nationalism and central economic planning. The government strategy was to transform the hydrocarbon sector into a highly integrated, state-owned complex under centralized management (Nashashibi et al. 1998). The national oil company, Sonatrach, which had been established in 1963, was initially only responsible for the transportation and marketing of hydrocarbon products. However, it soon also got involved in exploration, extraction, and processing. Sonatrach became a quasi-monopoly after Algeria began to nationalize assets of foreign oil companies in 1971. The scale and scope of operations soon caused managerial inefficiencies, and in 1982 Sonatrach was restructured, and its mission restricted to upstream oil and gas activities and hydrocarbon exports. However, the Algerian hydrocarbon sector remained sheltered from external competition and unable to engage in cooperative ventures with foreign partners. The resulting isolation inhibited technical progress and an effective adaptation to developments in the world energy market. Lack of investment in exploration and production capacity began to severely constrain the further development of the hydrocarbon sector.
9. Implicit subsidization of energy products due to administered prices as well as the promotion of energy-intensive heavy industries resulted in surging domestic energy demand, reducing the amount of hydrocarbon products available for exports. Algeria’s per capita energy consumption increased rapidly to levels several times higher than in countries with similar per capita incomes.3 During the 1970s, domestic consumption of refined products absorbed most of the production. Since the late 1980s, the authorities have gradually reduced the implicit subsidization of domestically consumed energy products and encouraged a switch from oil to natural gas consumption, thereby improving allocative efficiency, encouraging energy conservation, and freeing up oil production for exports.
10. Following the 1986 reverse oil price shock, the Algerian hydrocarbon sector was gradually opened to foreign participation. The 1986 hydrocarbon law opened the country for foreign investors engaged in oil exploration, under the terms of concession agreements, service contracts, or production-sharing contracts (Nashashibi et al. 1998). Amendments of the law introduced in 1991 further expanded the possibilities for foreign participation. In the early 1990s, a major investment plan was launched with the objectives to (1) boost exploration activity and develop new fields; (2) adopt enhanced recovery techniques at existing production sites; (3) expand the existing transportation infrastructure; and (4) increase and upgrade liquefaction capacity for LNG exports. In recent years, Algeria has been increasingly successful in attracting foreign capital and technology, in spite of the civil strife during most of the period. Intensified exploration, especially in the remote southern part of the country, also lead to numerous discoveries of additional hydrocarbon reserves, lifting the replacement ratio above unity.
11. Sonatrach still dominates the Algerian hydrocarbon sector, with foreign companies participating in only about 12 percent of production (EIU 2004). An initiative to further open up and restructure the sector failed with the blocking of the 2001 draft hydrocarbon law. The new legislation aimed to address Sonatrach’s double role as both a producing company and a regulator of the hydrocarbon sector by introducing a new regulatory structure which would have improved transparency, facilitated bidding and licensing, and increased foreign direct investment in the sector.
12. Algeria’s proven crude oil reserves are estimated at 11.3 billion barrels, which is about one percent of global proven crude oil reserves.4 At current extraction rates, reserves will be depleted within the next 26 years. However, increased exploration activity has led to numerous new hydrocarbon discoveries in recent years. While most of the discoveries have been made by foreign companies, the most recent find—a large oil field in the south of the country with estimated reserves of 360m barrels—was announced by Sonatrach in mid-February 2004. Algeria is still considered to be relatively under-explored, and recoverable crude oil reserves may range as high as 27.7 billion barrels according to the U.S. Geological Survey (USGS 2000). Moreover, the country has significant resources of lease condensate and natural gas plant liquids of between 3 and 8 billion barrels. Algeria’s Sahara blend is extremely light and sweet, which makes it one of the highest quality crudes worldwide.
13. Average crude oil production in Algeria was almost 1.2mn barrels per day (b/d) in 2003. Including 0.45mn b/d of lease condensate and 0.25mn b/d of natural gas plant liquids, total oil production reached more than 1.8mn b/d (about 2.4 percent of world oil production). While production of condensate and LPG has remained stable, average crude oil production surged more than 30 percent in 2003. Algeria has persistently exceeded its OPEC quotas in recent years (Figure 1).5 With the significant production increase in 2003, it has on average been producing almost 55 percent above its quota during the first half of 2004.6 Pointing to the country’s significantly increased production potential, the Algerian authorities are lobbying for an increase in the country’s OPEC quota share. Algeria’s quota fell from more than 4 percent (including Iraq) in the late 1980s to the present 3.2 percent (excluding Iraq).
Figure 1.Algeria’s OPEC Quota and Crude Oil Production, 1994–2004
Sources: OPEC and U.S. Energy Information Administration
14. More than 80 percent of Algeria’s total oil production is exported.7 The continuing substitution of natural gas for oil in domestic consumption will help free up additional oil for exports. With around 90 percent of exports, Algeria’s main market is Western Europe (Italy, Germany, France). In 2003, 45 percent of total oil exports were crude oil, 22 percent condensate, 20 percent refined products, and 13 percent LPG.
15. The Algerian authorities are implementing an ambitious plan to increase Algeria’s oil production capacity in the coming years. Crude oil production capacity already increased from 0.9mn b/d in 2001 to currently 1.2mn b/d. The target is to expand capacity to 1.5mn b/d by 2005 and up to 2.0 b/d by 2010. Increased exploration, the development of new fields, and the introduction of enhanced oil recovery systems in existing fields will necessitate the inflow of significant levels of foreign investment into the upstream oil sector. In 2004, Algeria opened its fifth licensing round for oil and gas, involving ten onshore blocks with an expected total foreign investment of at least $130 million.
16. Algeria has proven natural gas reserves of about 4.5 trillion cubic meters (tcm), ranking seventh in the world (just under three percent of world proven natural gas reserves).8 Known reserves will last for approximately 57 years at current extraction rates. As in the case of oil, significant reserve growth is expected in the coming years, and recoverable reserves could potentially be as high as 7.4 tcm. The most recent major natural gas discovery was announced in October 2003. Around 60 percent of Algeria’s reserves are associated gas.9
17. Total dry gas production reached 79bcm in 2003. 21bcm dry gas were consumed domestically, most of it for power generation. To a lesser extent, natural gas is used as a feedstock for the petrochemical industry. Algeria still subsidizes domestic gas consumption, which leads to inefficient energy use and could potentially limit the growth of exports. Natural gas is exported via pipeline10 and LNG tanker.11 Most of Algerian gas exports go to Western Europe, only about 2 percent are shipped to the United States. Algeria is extremely well situated to supply the fast growing European gas market, having large reserves in close proximity and a well-developed transportation infrastructure. It accounted for 20 percent of European gas imports in 2000. The Algerian Ministry of Energy and Mines expects gas exports to reach 85bcm/y by 2010, which would imply an annual growth rate of about 5.5 percent. While Algeria will benefit from robust growth of European gas demand, the liberalization of the EU natural gas market could threaten Algeria’s long-term sales arrangements, complicate contract negotiations, and lead to lower gas prices delinked from oil prices.
18. Several major natural gas projects are currently under development, In total, they are expected to increase natural gas production to up to 140bcm by 2020. The largest undertaking is the In Salah natural gas project, developed in a joint venture between Sonatrach and a foreign company. Other natural gas and condensate projects are Ohanet, In Amenas, and Gassi Touil. Additionally, feasibility studies are under way for new pipeline projects: The 8bcm/y Medgaz pipeline would link Algeria directly to Spain. Another 8-10bcm/y pipeline is planned to go to Italy via Sicily and would possibly extend further to southern France. A third potential project is a Trans-Sahara gas pipeline from Nigeria to the Mediterranean coast.
19. The Algerian treasury receives hydrocarbon revenues through royalties, taxes, and dividends from Sonatrach and its affiliates. An oil rent (redevance) of 20 percent is extracted from total value added (exports and domestic consumption). A direct tax of 85 percent is then levied on gross hydrocarbon profits (value added minus royalties and operation costs). Finally, as a state-owned enterprise, Sonatrach pays annual dividends to the treasury.
20. On average during 1989–2003, budgetary hydrocarbon revenues in Algeria accounted for almost two thirds of total budget revenues. In line with rising hydrocarbon export prices, their importance has increased significantly in relation to nonhydrocarbon revenues over the past few years. In 2003, total hydrocarbon exports amounted to $24 billion (98 percent of total exports of $24.5 billion) and budgetary hydrocarbon revenues to $17.5 billion. The average annual growth rate of budgetary hydrocarbon revenues (in US$) during 1989–2003 exceeded 7 percent. Growth was strongest during the price hikes in 1990 and 2000 (Figure 2). Apart from price developments, the strong increase of natural gas production and exports was the main factor driving hydrocarbon revenues.
Figure 2.Algeria: Hydrocarbon Revenues (In billions US$)
Sources: Algerian authorities and IMF staff estimates.
21. Hydrocarbon revenues have been far more volatile than nonhydrocarbon revenues, mainly due to the large fluctuations in world oil prices (Figure 3). Measured as a share of nonhydrocarbon GDP, the coefficient of variation of hydrocarbon revenues is three times higher compared to the respective coefficient for nonhydrocarbon revenues. Measured in terms of total GDP, hydrocarbon revenue volatility still exceeds nonhydrocarbon revenue volatility by a factor of two.
Figure 3.Algeria: Government Revenues
Sources: Algerian authorities and IMF staff estimates.
22. In 2000, the Algerian government established an (off-budget) hydrocarbon stabilization fund (Fonds de régulation des recettes) in order to (i) reconstitute the cushion of external reserves that had been used in 1998-99 during a period of low hydrocarbon revenues; (ii) to service the stock of public debt in the context of strictly limited domestic bank and nonbank financing capacities (by law, monetary financing of the treasury is subject to strict limits and nonbank financing is constrained by the still underdeveloped treasury bill market); and (iii) to smooth the longer-term profile of expenditures. The hydrocarbon stabilization fund does not have intergenerational transfer purposes.
23. Any hydrocarbon revenues in excess of those budgeted are deposited into the stabilization fund, which is currently not separated from the treasury account at the central bank. In the preceding years, the budget laws were built on conservative oil price assumptions of US$19 per barrel in 2000, $22 in 2001, and $19 in 2002 and 2003, while actual oil export prices averaged $28.5 in 2000, $24.8 in 2001, $25.2 in 2002, and $29 in 2003. This arrangement resulted in substantial gross inflows to the stabilization fund, amounting to a total of DA1,052.5 billion at end-2003 ($14.5 billion, or 20.5 percent of 2003 GDP).
24. The 2004 budget law introduced exceptional advances by the central bank to the Treasury as an additional source of inflows to the stabilization fund. This change is related to the new law on money and credit. It authorizes the central bank to make such advances to the Treasury if they are intended exclusively for the active management of the external debt.
25. By law, the amounts accumulated in the fund can be used to (i) finance the budget deficit in case of lower-than-budgeted hydrocarbon revenues, and (ii) reduce the outstanding national debt. Regarding the former, the 2004 draft budget law clarified that the amount of money that can be drawn from the fund is limited to the shortfall in hydrocarbon revenues resulting when realized hydrocarbon prices are lower than those projected in the budget law. The latter use opens a serious loophole in the budgetary process: the use of financial resources of the stabilization fund for amortization payments has led to an actual use of oil revenues for additional spending (often in the context of supplementary budgets) which has resulted in budget deficits much larger than envisaged in the budget law.
26. So far, actual hydrocarbon prices stayed consistently above those budgeted, and consequently the authorities’ policy has been to restrict the use of the fund’s resources to financing debt amortization payments. At end-2003, total credits to the fund were DA1,052.5 billion ($14.5 billion, or 20.5 percent of 2003 GDP), while drawings for debt amortizations from 2000 to 2003 added up to DA484.1 billion ($6.7 billion, or 9.4 percent of 2003 GDP). Therefore, the net amount accumulated at end-2003 was DA568.4 billion ($7.8 billion, or 11.1 percent of 2003 GDP). This amount represents a mere 7.3 percent of the total government hydrocarbon revenues of DA7,739 billion in the period 2000–03.
|Actual average oil export price (in $)||28.5||24.8||25.2||29.0||37.4|
|Budgeted oil export price (in $)||19.0||22.0||19.0||19.0||19.0|
|Stabilization Fund (in DA bn)||232.1||249.0||275.5||568.4||…|
|Accumulation (in DA bn)||453.2||123.9||26.5||448.9||616.3|
|Utilization (in DA bn)||221.1||107.0||0.0||156.0||…|
|Stabilization Fund (in percent of GDP)||5.7||5.9||6.2||11.1||…|
|Accumulation (in percent of GDP)||11.1||2.9||0.6||8.8||10.5|
|Utilization (in percent of GDP)||5.4||2.5||0.0||3.0||…|
C. Economic Policy Challenges
27. Economies with large hydrocarbon industries have certain unique economic characteristics: (i) hydrocarbon reserves are exhaustible; (ii) reserves and future price paths are uncertain; (iii) hydrocarbon prices are extremely volatile; (iv) the hydrocarbon sector typically is an enclave more or less separated from the rest of the domestic economy; (v) hydrocarbon revenues originate largely from abroad; and (vi) hydrocarbon revenues are often an important source of total government revenue. From these special characteristics result the following challenges for economic policy:
- Efficient use of hydrocarbon revenues.
- Fiscal sustainability with a view to the finite and uncertain hydrocarbon revenue stream;
- Intergenerational equity considerations with regard to the intertemporal distribution of the natural resource wealth;
- Transmission of hydrocarbon sector volatility into the nonhydrocarbon economy through fiscal policy, thus hurting private sector development and growth, reducing public spending quality, and creating a deficit bias;
- Dutch disease phenomena through real exchange rate appreciation, induced by large foreign exchange inflows resulting from hydrocarbon export revenues;
- Governance problems and rent-seeking behavior due to the concentration of revenues from the hydrocarbon sector and their significance for the government budget.
28. Given that most hydrocarbon revenues accrue to the government, these policy challenges relate to primarily fiscal policy decisions, although there are important implications for monetary policy as well. Prudent macroeconomic policy would strive to insulate the nonhydrocarbon economy from the volatility of the hydrocarbon sector, sterilizing excess foreign exchange inflows, and diversifying the fiscal revenue base, while at the same time ensuring long-run fiscal sustainability and taking into account intergenerational economic equity concerns.
Efficient Use of Hydrocarbon Revenues
29. Algeria’s large hydrocarbon resource endowments can be very beneficial for the economy. Used wisely and efficiently, the country’s hydrocarbon wealth opens up opportunities to achieve broad economic objectives, including increasing growth and employment. Government hydrocarbon revenues can be spent to satisfy current economic needs and to invest in the country’s future economic potential. Naturally, the use of hydrocarbon revenues for capital and social spending is high on the government’s political and economic agenda. However, Algeria has not at all times been successful in efficiently using its hydrocarbon wealth. On the contrary, volatile public spending has often had damaging effects, harming the private nonhydrocarbon sector, as well as creating uncertainty and adjustment costs. At the same time, the public sector has not always been able to use hydrocarbon wealth productively in the form of growth-enhancing investments. Like other natural resource based economies, Algeria has so far not been able to utilize its hydrocarbon wealth to create the necessary conditions for sustained faster growth and economic development.12
30. Oil and natural gas are non-renewable resources, and the size of recoverable reserves is subject to considerable uncertainty. Even though natural resource endowments can generate significant government revenues over several generations, fiscal policy finally will have to manage the transition to a situation where the natural resources will be depleted (Bjerkholt 2002). In order to meet its inter-temporal budget constraint, the government should save a part of current hydrocarbon revenue to be able to maintain spending levels in future periods. One possible way of achieving long-run sustainability of fiscal policy with hydrocarbon revenues is for the government not to spend out of its current hydrocarbon income, but out of its permanent income (see section IV). Alternatively, fiscal policy could follow rules imposing limits on expenditures or a certain budget deficit measure, and might additionally restrict government’s ability to borrow (Davoodi and Fasano 2004).
31. In addition to the exhaustibility of natural resource reserves, government has to take into account the uncertain nature of future hydrocarbon revenue streams. Hydrocarbon revenues are notoriously difficult to forecast. The long-term path of hydrocarbon prices is highly uncertain, and prices exhibit strong volatility in the short term.13 Past efforts of long-term price projections have been regularly far off the mark.14 The predictability of hydrocarbon prices depends on their statistical properties. Empirical studies have been inconclusive so far as to whether oil prices are mean reverting or follow a random walk.15
The impossibility to calculate accurately the flow of revenue even in the short term necessitates the early accumulation of precautionary savings in the form of liquid financial assets in order to provide a cushion for fiscal expenditures in years with unexpectedly low hydrocarbon revenues.
32. Other ways to reduce the impact of future revenue shortfalls are targeting persistent surpluses (Alier and Kaufman 1999), diversifying government revenue sources, or the use of contingent financial instruments (Daniel 2001). Raising the royalty rate and lowering the hydrocarbon tax rate would also reduce the impact of oil price volatility on government hydrocarbon revenues (Bjerkholt 2002). Finally, government economic policy could aim at enhancing growth of the non-hydrocarbon sector which could be potentially taxed.
33. Natural resource endowments constitute a part of national wealth, and the revenues that are generated by extracting them represent a depletion of this wealth. Hydrocarbon proceeds therefore should not be treated as current income but as financing (Tersman 1991, Barnett and Ossowski 2002). The size of hydrocarbon wealth in the ground can be estimated by the present value of the rent earned when it is extracted. Ensuring intergenerational equity would call for a preservation of wealth over time by saving and investing at least part of the rent.
34. The term “intergenerational equity”, however, needs further specification, depending on how the welfare of future generations is valued relative to that of the present generation. In the recent economic discussion, the two most popular targets chosen are keeping the government’s net wealth constant either (i) in real terms, or (ii) in real terms per capita. Following the first target would imply that the government could fully spend the real return on its net wealth, favoring the current generation at the expense of future generations, as a constant stock of wealth will in the future be shared among a larger population. Pursuing the second target would be more restrictive on current spending, allowing the provision of a time-invariant level of public goods to all citizens over time (Davoodi and Fasano 2004).16 Defining what constitutes economic equity between generations is ultimately a political decision, depending on the government’s social welfare function.
35. As indicated above, the uncertainty regarding ultimately recoverable reserves, the future hydrocarbon revenue stream, or society’s discount rate create a precautionary savings motive in addition to the intergenerational equity motive (Katz et al. 2004).
Volatile Fiscal Expenditure
36. Hydrocarbon price volatility is often transmitted to the nonhydrocarbon economy through fiscal expenditure policy. Volatile government expenditures have a negative impact on the economy by increasing uncertainty about aggregate demand as well as through adjustment costs for frequent factor reallocation. Fiscal policy induced “boom-bust-cycles” therefore hurt private sector development, in particular long-lived investment, and are in part responsible for the growth underperformance and low diversification of hydrocarbon-based economies.
37. Government expenditure volatility entails significant fiscal costs in the form of reduced spending quality and efficiency, as large expenditure swings are difficult to manage. In times of rising revenues, it proves regularly hard to resist political pressures to increase expenditures in line with revenues (Talvi and Végh 2000). With planning, implementation, and management capacity being limited, the risk increases that additional fiscal resources are used for financing unviable capital projects and costly current expenditure programs. The adverse effects are intensified by corruption and governance problems connected with large spending programs. When government expenditure has to be reduced, capital and maintenance expenditure mostly bear the bulk of the adjustment burden, which may also be a source for low capital productivity and economic growth in hydrocarbon-producing economies.
38. Additionally, volatile fiscal expenditures often lead to a deficit bias of fiscal policy, as spending programs become entrenched. The implementation of expenditure cuts regularly turns out to be more difficult politically than the initial expenditure increases. As a result, fiscal imbalances build up, and the government is forced to either increase borrowing in an environment of increasing borrowing costs (Hausmann and Rigobon 2002) or to abandon capital projects and social spending programs. While domestic borrowing would be inflationary or crowd out credit to the private sector, external borrowing would increase fiscal vulnerability; introducing forced expenditure cuts in a disorderly, disruptive fashion could lead to social instability and reduced future growth (Barnett and Ossowski 2002).
39. Since oil and natural gas production is for the most part exported, hydrocarbon revenues bring about sizable foreign exchange inflows into the economy. Increased domestic use of external hydrocarbon revenues generally leads to an appreciation of the real exchange rate, which is unrelated to productivity improvements in the nonhydrocarbon sector of the economy. The appreciation of the domestic currency makes domestically manufactured goods less competitive, increasing imports, and decreasing exports. This phenomenon is commonly referred to as Dutch disease (Corden, W. M. 1984).
40. The Dutch disease phenomenon can be described best in a simple model of an economy with three sectors (Wakeman-Linn et al. 2004): a traditional tradable goods sector, a nontraded-goods sector, and the hydrocarbon sector. Rising world hydrocarbon prices lead to higher foreign exchange inflows via hydrocarbon export receipts. Higher real incomes from the hydrocarbon sector lead to increased expenditures on both tradable and nontraded goods. As a result, the real exchange rate appreciates, as nontraded goods prices increase, while tradable goods prices—which are determined in the international market—remain constant. Faced with higher factor prices which cannot be passed through to goods prices, the tradable goods sector becomes less profitable and looses international competitiveness. The sector contracts, and resources move from the tradable goods sector to the nontraded goods sector. Depending on the flexibility of the domestic economy and the ability of the nontraded goods sector to absorb labor freed up in the tradable goods sector, unemployment increases during a—possibly prolonged—transition period.
41. Close coordination of fiscal, monetary, and exchange rate policies is required to avoid excessive real exchange rate appreciation connected with the Dutch disease phenomenon. In addition, productivity-enhancing structural reforms can further help preserving the competitiveness of the nonhydrocarbon private sector.
42. In the case of Algeria, adverse Dutch disease effects can be controlled and minimized by an appropriate fiscal management of hydrocarbon revenues. Being a mainly export-oriented industry situated in remote areas, and with high capital and low labor intensity, the hydrocarbon sector has strong enclave characteristics. An increase in world hydrocarbon prices does by and large not directly affect domestic demand. Most of the increase in hydrocarbon export revenues accrues directly to the government. Therefore, the main channel of transmission to the nonhydrocarbon economy is government expenditure.
43. The hydrocarbon sector generally has a much higher significance for fiscal revenues than its share of GDP would suggest. Effectively managed, large hydrocarbon rents should provide a country with the resources to finance economic development and necessary structural reforms, including measures to reduce the political and social costs of those reforms (social safety net). However, the experiences of natural-resource-rich countries show that natural resource revenues often tend to be spent on current consumption, rather than to finance infrastructure projects conducive to private sector growth, investment in human capital, or structural reforms (Wakeman-Linn et al. 2004).
44. The easy availability of hydrocarbon revenues in periods with high world market prices reduce pressures for economic reforms, encourages overoptimistic expenditure plans, and reduces incentives for appropriate planning and monitoring of spending projects. At the same time, political pressures for increased government spending intensify.
45. The high concentration of hydrocarbon revenues and their large share in total budget revenues also make their use prone to lead to widespread corruption and rent-seeking behavior by special interest groups. Improving transparency and accountability in the fiscal management of hydrocarbon revenues and a proper regulation of hydrocarbon sector operations is therefore of utmost importance for ensuring good governance.
D. Long-Term Wealth Preservation
46. In an oil and gas producing economy, hydrocarbon reserves will eventually be depleted, and hydrocarbon earnings as a government revenue source will consequently vanish. On the grounds of fiscal sustainability and intergenerational equity considerations, the main challenge for fiscal policy in the long run is deciding how to allocate the economy’s wealth (including hydrocarbon wealth) across time (Barnett and Ossowski 2002).
47. In the following, the permanent income framework will be employed as one possible way of ensuring intergenerational economic equity and long-term sustainability of fiscal policy. The section focuses on issues of wealth preservation and fiscal sustainability. The discussion does not cover broader concerns such as social returns of alternative uses of hydrocarbon revenues, or how to use oil revenues efficiently for the purpose of employment creation.
48. Intertemporal optimization would imply a prudent fiscal policy preserving government net worth, which would guarantee a constant consumption out of wealth for all generations (Solow 1974, 1986). The permanent income hypothesis assumes that the government does not spend out of its current income, but out of its permanent income, which is the notional income stream from its net wealth (Davoodi and Fasano 2004). Fiscal policy is sustainable over the long run, if the government’s primary nonhydrocarbon deficit is smaller or equal to the country’s permanent income out of the government’s net wealth. The primary rather than the overall deficit is the relevant concept because net interest income is considered to change net wealth.
49. Two alternative long-run frameworks for fiscal policy will be considered: The first keeps government’s net wealth constant in real terms, which implies constant real spending in each period. The second aims at preserving the same wealth in per capita terms, entailing rising government spending in line with population growth.
50. In general, government net wealth encompasses the sum of hydrocarbon wealth, financial assets net of government debt, and nonfinancial wealth (Davoodi and Fasano 2004). However, valuation of government nonfinancial wealth (such as physical capital and ownership of commercial or quasi-commercial entities) is generally difficult to determine and data usually not available.17 Furthermore, most government nonfinancial assets, such as infrastructure capital, do not provide a regular income stream to the government if at all. For these reasons, nonfinancial wealth is excluded from the following analysis. The results could be qualified and adjusted, if more information about the valuation of government nonfinancial wealth were available. However, it is not certain in which direction the valuation of total government net wealth would change if government nonfinancial wealth would be considered, since both nonfinancial assets and liabilities would have to be included.
It might well be that quasi-fiscal deficits from loss-making public enterprises18 and contingent liabilities likely existing in the social security system and local municipalities outweigh the future income from nonfinancial assets.19
Abstracting from nonfinancial wealth, the relevant policy variable is total government net wealth Wt as the sum of hydrocarbon wealth Ht and net financial wealth Ft:
Hydrocarbon wealth is defined as the present discounted value of projected future government hydrocarbon revenue up to period T, in which hydrocarbon reserves are finally depleted:
In equation (2), real hydrocarbon revenue in period t is given by rt, while i represents the real interest rate.
Preservation of government net worth requires that government spending in each period is limited to the implicit return on government wealth. If total wealth is to be kept constant, hydrocarbon production can be thought of as a portfolio transaction in which natural resource assets extracted from the ground are converted into financial assets. Hence, financial wealth must increase to the extent that hydrocarbon wealth is drawn down. This requires that part of oil revenue is saved.
The permanent income framework can be applied to operationalize the decision problem of the natural resource based economy.20 The permanent income is the maximum amount of current hydrocarbon revenues that can be used for actual spending each year without reducing total wealth. Hydrocarbon revenue is the sum of the decline in oil wealth between periods t and t-1 and the implied return on hydrocarbon wealth in period t-1:
Assuming certainty, the required savings out of oil revenue can be derived from the targeted financial wealth compared to the stock of financial wealth in the previous periods:
The total hydrocarbon revenues are larger than the required savings to accumulate income-generating assets or to reduce outstanding debt as the interest earned during the period will be added to the financial assets. By rearranging equations (4) and (5) and inserting into (3), an expression for government spending financed by permanent income from hydrocarbon wealth can be derived:
The government intertemporal budget constraint can be written as
where zt is nonhydrocarbon revenue excluding net interest income, which is given by it (Wt-1+ st), and et stands for the government’s primary expenditure and net lending. Primary expenditure excludes interest payments on public debt and includes current spending and public investment in physical and human capital. The difference between revenues and expenditures leads to a change in the government’s net worth.
Following this upper limit for the nonhydrocarbon deficit will maintain real government wealth constant, as sufficient hydrocarbon revenue is saved to accumulate financial assets. Over time, the targeted savings of hydrocarbon revenues will turn negative and the primary nonhydrocarbon deficit will be financed increasingly by interest revenues from accumulated assets. The return on these assets will ensure that the primary nonhydrocarbon deficits can be sustained even after the hydrocarbon revenues dry up.21
Targeting a constant level of hydrocarbon wealth with population growth will lead to falling levels of per capita wealth, which would violate intergenerational equity requirements. To account for this, the above framework can easily include the population growth rate nt in order to keep real wealth per capita constant over time:
Constant real wealth per capita requires that total real wealth grows in line with population. Therefore, a higher share of current hydrocarbon revenue has to be saved and invested in income-generating financial assets.
The fiscal expenditure framework for keeping wealth per capita constant can be derived by inserting equations (4) and (6) into (12). Under this rule, government spending financed by permanent income from hydrocarbon wealth should equal the return on total wealth adjusted for the population growth rate plus the interest earned on savings during the current period:
In this case, the government intertemporal budget constraint is:
Consequently, the net primary nonhydrocarbon deficit can be written as:
51. The permanent income framework has several desirable properties (Davoodi 2002). It is forward-looking in that it assumes that expenditures are financed not by current income but out of permanent income from total government wealth. Following a permanent income framework over the long term will smooth the government spending path of hydrocarbon wealth over time. Assuming certainty about the present value of future hydrocarbon revenues, a permanent income-oriented fiscal policy is by construction sustainable.
52. However, critics argue that exactly because of the enormous uncertainties concerning reserves, prices, extraction costs, the rates of return on the savings portfolio, or the appropriate discount rate to reflect society’s time preference, there is nothing permanent about the hydrocarbon wealth underlying the calculation of permanent income (Bjerkholt 2002). Additionally, the permanent income framework would call for borrowing towards future earnings in countries that are in an early phase of developing their hydrocarbon resources – a dangerous prescription in view of the volatility and uncertainty of hydrocarbon revenues and perhaps high borrowing costs.22 Several countries, such as Algeria and Nigeria, borrowed heavily against anticipated future hydrocarbon income and later suffered from major macroeconomic crises when the revenue forecasts turned out to be wrong. Finally, the permanent income framework does not consider social returns from employment creation or physical investment.
53. Consequently, the permanent income framework should be supplemented to account for the fact that the permanent income estimate is afflicted with significant uncertainty. This would generally lead to a more conservative fiscal stance (while accounting for social returns could allow higher expenditure). For example, the permanent income framework could entail a nonborrowing constraint, which would mean that the government would finance its nonhydrocarbon deficit solely from hydrocarbon revenues. The framework should also account for some additional precautionary savings to account for possible downward revisions of permanent income in the future due to changed reserves, market conditions, or technological obsolescence of the natural resource.
54. Finally, estimates of hydrocarbon wealth and permanent income have to be reconsidered and adjusted continuously, as new information about reserves or changing market conditions are obtained. Likewise, results should also be adjusted, in case reliable data on the valuation of government nonfinancial wealth become available.
E. Efficient Management of Hydrocarbon Wealth
55. Managing hydrocarbon wealth efficiently requires portfolio decisions at various levels. First, the authorities have to decide on the rate of depletion of the hydrocarbon reserves, that is, on the speed with which physical resource assets are converted into financial assets. Second, policymakers face the intertemporal optimization problem of how much of the hydrocarbon revenues to spend, and how much to save for wealth preservation for future generations. For this, the permanent income framework discussed above can serve as a guideline. Third, decisions will have to be made regarding the alternative investments of hydrocarbon savings.
56. The decision on the optimal depletion rate depends on the relative returns on the alternative assets in the present and future periods, and it consequently will be largely influenced by the assumptions made concerning the future price path of hydrocarbon products. An argument could be made that in order to reduce the level of uncertainty as well as the dependence on the resource markets, an accelerated rate of depletion should be chosen. Moreover, the Hotelling rule suggests that physical capital has a higher marginal productivity than natural resource capital (Stiglitz 1974, Cairns and Davis 1998). This would justify a rapid depletion of the hydrocarbon reserves in order to finance the build up of physical and human capital to boost the economy’s growth (Davoodi 2002).
57. Financial assets created by the sale of hydrocarbon products could be invested in a diversified portfolio, thus reducing risk. Risk diversification could also be achieved by selling off a large share of property rights to the resource endowments in the international market – that is, in principle there is no need to physically extract the natural resource asset first. However, in practice this may not be possible because the market for large-scale sales of natural resource endowments does not exist (Bjerkholt 2002). Similarly, there are also economic, technological, and political restrictions to the extent to which depletion rates can be increased. Mainly, Algerian hydrocarbon production will be limited by upstream investment, sustainable field management, demand developments, and OPEC quotas in the case of oil.
Alternative Investments of Hydrocarbon Savings
58. Regarding the share of hydrocarbon revenues to be saved for long-term wealth preservation purposes, there are three main alternative uses. The authorities could decide to further build up productive capacity in the form of physical and human capital in order to increase the nonhydrocarbon economy’s growth potential. On the other hand, they might choose to accumulate financial wealth and invest it either domestically or abroad, or they could prefer to repay outstanding government debt.
Investing in Physical Assets
59. Efficient government investment in productivity-enhancing infrastructure and human capital can be expected to increase the return on private capital and contribute to meeting the key challenges facing Algeria of creating employment and boosting the country’s growth potential. However, regarding fiscal sustainability, the financial returns to government investment would have to be rather high. Unlike the private sector, the government’s financial return is by and large restricted to what it can retrieve by way of higher tax revenue (Barnett and Ossowski, 2002). In most cases it seems unlikely that investment in physical assets will generate higher financial returns for the government (in the form of higher future tax revenue) than a respective investment in financial assets (Fischer and Easterly 1990), particularly if tax rates on the realized returns in the private nonhydrocarbon sector are low. Choosing to invest hydrocarbon revenues in public physical assets will therefore generally alter the fiscal sustainability situation.
60. Government capital expenditure could also be seen as a consumer durable generating social welfare and employment, instead of as productive investment generating only financial returns (Barnett and Ossowski 2002). If it can be assumed that the public capital stock is initially at a suboptimal level, giving up some of the initial hydrocarbon wealth in order to allow larger primary nonhydrocarbon deficits could be justifiable for some time until the capital stock reaches its equilibrium level.
61. On the other hand, in the short term the absorptive capacity of the economy may not be sufficient for large-scale domestic investment, which could lead to poor spending quality, inflation and crowding out of the private sector. Injecting a large share of the foreign exchange inflow earned from hydrocarbon exports into the domestic economy could cause the Dutch disease phenomenon by pushing prices of nontradable goods up, thus inducing an appreciation of the real exchange rate and eroding the competitiveness of the nonhydrocarbon tradable goods sector.
62. Since public physical assets are less liquid than financial assets, investment in physical assets should make an allowance for higher precautionary savings. Also, policy makers have to take into account the related implicit commitments, such as future maintenance costs, contained in capital expenditures.
63. Practical experiences with public investments in productive capacity have been rather disappointing in hydrocarbon based economies in general, as well as in Algeria specifically (Nashashibi et al. 1998). Limited institutional capacity, insufficient maintenance and poor management, as well as governance problems caused by non-transparent procedures, low accountability and rent-seeking behavior often lead to poor spending quality. Government investment in the public enterprise sector has been particularly inefficient in Algeria, creating large loss-making public enterprises that have been resistant to productivity enhancing reforms. Furthermore, the needs of state-owned enterprises for credit have reduced the limited financial resources available for private sector development. Instead of creating a reliable government revenue stream, the public enterprise sector posed a growing financial burden on government finances, as repeated attempts at public enterprise restructuring failed (Floerkemeier 2003).
64. From a fiscal sustainability viewpoint, government investment decisions should be based on the return that the government can expect. From this perspective, the problem is a portfolio decision between financial and physical assets (Barnett and Ossowski 2002). From an economic development point of view, however, Algeria has substantial development needs and an insufficient stock of infrastructure capital. The availability of hydrocarbon wealth could lower the financing cost of government investment; however, it would not make investments in the nonhydrocarbon sector more worthwhile as such. Decisions on government investment projects should thus be made on the basis of cost-benefit criteria, independent of the availability of financial resources from hydrocarbon revenues.
Investing in Financial Assets
65. When the Algerian government decides to accumulate hydrocarbon savings in the form of financial assets, it can invest those assets either domestically or abroad. Given the objective of supporting growth of the domestic economy, the government might have a preference of investing hydrocarbon savings locally. However, there are two important arguments against this. First, investing assets domestically would transmit hydrocarbon revenue volatility to domestic financial markets as the government buys and sells such assets (Davoodi and Fasano 2004). Second, the dangers of the Dutch disease phenomenon connected with large-scale foreign exchange inflows (real exchange rate appreciation leading to a deterioration of competitiveness of the nonhydrocarbon tradable goods sector) would call for sterilizing a large part of hydrocarbon revenues by investing them in financial assets abroad instead of in domestic financial assets.
66. Investing hydrocarbon savings in an international portfolio of financial assets would warrant a stable flow of government income largely unaffected by domestic economic developments. If the available resources are invested in sufficiently liquid assets, the government would ensure fiscal flexibility, should unexpected financing needs arise. Oil producing countries sometimes choose to invest internationally in the downstream hydrocarbon sector or in related industries, such as petrochemicals, in order to secure markets for their products. However, for diversification and risk reduction purposes, investments ought to be independent from or even negatively correlated with the hydrocarbon market. The downside of investing hydrocarbon savings in financial assets abroad lays in the exchange rate risk and the need to foster political acceptance in the presence of pressing domestic investment needs, such as for infrastructure or human development. Especially the latter argument applies in the case of Algeria.
67. Countries with substantial external debt normally have to pay a sovereign premium. In this case, the government should use its hydrocarbon revenues to rapidly pay off its expensive debt. Because of the sovereign premium, the government faces two interest rates, a higher one for borrowing and a lower one for its gross savings (Barnett and Ossowski 2002). As long as the debt is positive, the sovereign premium increases the return to savings. Consequently, the government should as much as possible repay its debt ahead of schedule and increase its net savings in order to take advantage of the higher interest rate. Another situation arises in countries with access to concessional credit, where debt service on existing debt might be below the returns that would be achieved by investing hydrocarbon revenues in financial assets.
F. Short- and Medium Term Stabilization
68. Fiscal policy faces the challenge of how to inject the hydrocarbon resource rent into the economy as fiscal expenditure. The main instrument to avoid a strong real exchange rate appreciation causing Dutch disease is to sterilize part of the foreign exchange inflow by investing hydrocarbon proceeds in foreign assets, or to pay off external debts. Spending on investment rather than consumption could also help in sterilizing parts of the foreign exchange inflows, insofar as capital expenditures have a comparatively high import content. Structural policies encouraging private sector saving can complement fiscal policy in restraining real exchange rate appreciation (Katz et al. 2004). To the extent that increased domestic absorption is permitted during a period of hydrocarbon windfall revenues, monetary policy should accommodate the resulting increase in real money demand through an expansion of money supply in order to limit an excessive appreciation of the real exchange rate (Wakeman-Linn 2004). However, in the view of the limited depth and development of the financial market in Algeria, which constrains the scope and effectiveness of open market operations by the central bank, it remains essential to follow prudent fiscal policies and strengthen coordination of macroeconomic policies between the Ministry of Finance and the central bank.
69. The volatility of oil prices translates directly into volatile fiscal revenues and can severely impact the conduct of fiscal policy in countries, like Algeria, where hydrocarbon proceeds account for a large share of the budget. Because world hydrocarbon prices are beyond the control of the authorities, fiscal policy has to develop strategies confronting unexpected and large swings in fiscal cash flow. As described above, government spending is the main channel transmitting hydrocarbon sector volatility to the nonhydrocarbon sector.
70. In order to prevent the revenue volatility from spilling over into the nonhydrocarbon economy, the use of hydrocarbon revenue should be decoupled from the current earnings. Expenditures should be budgeted independently from current hydrocarbon revenues, and unexpected revenue changes sterilized through changes in public debt levels or financial assets holdings.23 The implementation of such a fiscal policy could be aided by formulating budgets within a medium-term framework and by introducing fiscal guidelines as an anchor for policymakers. Medium-term budgetary frameworks increase fiscal transparency by revealing future spending implications of present expenditure increases, such as maintenance cost of capital projects, thereby containing short-run pressure for expenditure increases in response to temporarily high hydrocarbon revenues. A fiscal framework linked to an appropriate indicator of the fiscal stance would smooth expenditure reactions to revenue volatility.
Indicators of the Fiscal Policy Stance
71. The primary nonhydrocarbon fiscal balance (PNHB) is the key indicator for assessing the direction and sustainability of fiscal policy in a hydrocarbon resource rich economy. The reasoning for excluding hydrocarbon proceeds is that natural resource revenues are a form of financing rather than income.24 The PNHB is a variable unaffected by hydrocarbon price volatility and therefore largely under the control of the authorities. It allows the targeting of a stable fiscal policy in line with economic developments in the nonhydrocarbon economy. Changes in the fiscal stance related to hydrocarbon price fluctuations are directly reflected in changes of the PNHB. Hence, the PNHB indicates the impact of fiscal policy on domestic demand.
72. In contrast, the overall balance is affected heavily by the development of hydrocarbon revenues. Targeting a balanced overall balance would lead to a full transmission of hydrocarbon revenue volatility to the nonhydrocarbon economy and consequently be destabilizing. Additionally, this fiscal policy strategy does not account for the gradual depletion of oil wealth, and the overall balance will have to be adjusted dramatically when hydrocarbon resources are exhausted or should they become technologically obsolete.25
73. The PNHB should be used as the basis of budget determination and should be published in budget documents. It will be negative to the extent that current oil revenue (or income from financial assets from oil revenue saved in the past) is used to finance budget expenditure. The sustainable target value for the PNHB depends on the estimate of the permanent income stream resulting from total hydrocarbon and financial wealth. The specific fiscal framework targeting the PNHB could, however, allow for some flexibility or automatic countercyclical response to shocks affecting the nonhydrocarbon sector.
74. A price-based deficit rule would be a possible alternative to a fiscal guideline targeting a specific PNHB. Such a rule would aim for a balanced overall budget using an estimate of the long-term average, or “permanent”, hydrocarbon price. Like the PNHB-based framework, this fiscal rule would eliminate the impact of hydrocarbon price volatility on budget expenditures. In addition, the price-based rule has an advantage in terms of simplicity. It is easily understood and the outcome is readily observable. However, the rule would not be able to fully decouple the budget from all sources of oil revenue volatility, such as changes to production, extraction costs, the taxation regime, and the impact on oil revenue from exchange rate movements (Baunsgaard 2003).
75. Another alternative would be to follow an expenditure rule, according to which fiscal policy would aim at maintaining expenditure in real terms or in real terms per capita. Adherence to this rule would also make the expenditure program independent from hydrocarbon revenue volatility. The advantages of an expenditure rule compared to the PNHB based framework are its simplicity and transparency, which makes it straightforward to explain to the public and easy for the public to monitor observance to the rule, thus enhancing fiscal policy credibility (Wakeman-Linn et al. 2004). Nevertheless, it has to be combined with a permanent financing constraint to guarantee long-run fiscal sustainability (Davoodi and Fasano 2004).
76. Independent from the guideline selected, a strong case can be made for building up a cushion of reserves—which would have to be large enough to temporarily absorb a possible adverse shock to hydrocarbon prices—before fully implementing a rules-based fiscal framework. That is, initially the guideline should be applied in an asymmetric manner until sufficient financial assets have been built up to support adherence to the framework. Only if the government is not liquidity constrained and has sufficient access to credit at reasonable cost, will it be able to absorb unanticipated adverse revenue shocks without forced expenditure adjustments. Even if such a shock should turn out to be prolonged or permanent, a country with a strong financial position could afford to adjust its fiscal stance gradually through a mix of adjustment and financing (Barnett and Ossowski 2002).
77. In response to the difficulties of managing hydrocarbon revenue volatility and to supplement rules-based fiscal spending frameworks, a number of countries have created saving funds or’such as Algeria—revenue stabilization funds (Fasano 2000, Davis et al. 2001). The idea is to institutionalize savings during revenue windfalls and dissavings during price downturns. Liquidity accumulated in a stabilization fund provides fiscal policy with some degree of self-insurance, as international lending particularly to primary commodity producers tends to be positively correlated with commodity export prices (Davoodi and Fasano 2004).
78. However, hydrocarbon funds as such do not constitute fiscal rules and do not place formal restrictions on the conduct of expenditure policies. Several countries experienced incidents in which assets were accumulated in stabilization and saving funds while the government simultaneously increased borrowing to finance an overall deficit. To avoid this paradoxical situation, hydrocarbon funds should be made the only legal source of financing the PNHB (financing fund). To be effective, hydrocarbon funds should not be set apart from the budget process, and they need to be controlled by stringent transparency, fiduciary, and accountability mechanisms.
79. Stabilization funds are difficult to design and operate. Their major flaw is the setting of a reference price that will automatically determine flows into or out of the fund. Often, long-run average prices serve this purpose. However, due to changing realities or political pressures, reference prices tend to be adjusted more or less frequently (as has also happened in Algeria in 2001), calling the very purpose of the stabilization fund into question.
80. In general, financing funds—such as the Norwegian State Petroleum Fund—are preferable to stabilization funds. Financing funds do not have the rigid and arbitrary reference price rules, but serve as a government savings account through which all hydrocarbon revenues are channeled. In turn, the fund serves as the sole financing source of the budget deficit. Consequently, the net inflow into a financing fund equals the overall fiscal balance.
G. Sustainable Use of Hydrocarbon Revenues in Algeria: Long-Term Simulations
81. In the following simulations, the permanent income framework will be applied to Algeria.26 Projections of the net present value (NPV) of the future hydrocarbon income stream and the resulting permanent income are made for the period 2004 to 2050. The results can serve as a guideline for the long-term sustainable fiscal management of hydrocarbon resources. Due to the significant uncertainty connected with long-term estimations of the NPV of hydrocarbon income, the results should be interpreted cautiously and be updated when new information about recoverable reserves become available, the taxation regime and institutional environment of the Algerian hydrocarbon sector change significantly, or international market developments significantly deviate from the assumptions made.
82. As discussed above, fiscal policy should adopt a rather cautious stance and regard the permanent income estimates as upper limits of the primary nonhydrocarbon balance, while further precautionary savings considerations should be taken into account. To account for uncertainty, several alternative scenarios with differing assumptions concerning recoverable reserves and hydrocarbon prices were carried out. The following subsections explain the methodology applied, describe the underlying assumptions, present the results of the alternative scenarios together with some policy recommendations, and conclude with some considerations about the sensitivity of the simulation results to changing assumptions.
83. Algeria produces a variety of hydrocarbon products, each of which accounts for a substantial share of the production and export portfolio: crude oil, condensate, refined products, LPG, LNG, and dry gas. For the present simulations, all products will be considered. However, prices of the various hydrocarbon products are highly correlated. To simplify the analysis, it seems justifiable to combine them into two groups and use weighted average prices and aggregate volumes for the projections: Crude oil, condensate, natural gas liquids, and refined products are aggregated into “total oil”, while LNG and dry gas are grouped in the category “total gas”.27’ 28 Projections of the NPV of the future revenue stream are carried out for these two categories separately and then added up to arrive at the total hydrocarbon income NPV.
84. Taking the estimates of the NPV of Algeria’s hydrocarbon revenues as a starting point, two alternative permanent income-based fiscal targets of hydrocarbon wealth preservation are considered: (i) constant real wealth, and (ii) constant real wealth per capita (Figure 4). The first target would allow larger nonhydrocarbon deficits over time, but would not account for Algeria’s significant population growth. Depending on the importance policymakers put on intergenerational equity considerations, keeping wealth constant per capita in order to equally distribute wealth across generations might be the preferred choice.
85. Alternative simulations are carried out using various assumptions about recoverable hydrocarbon reserves and future hydrocarbon prices. Sensitivity analyses were conducted to evaluate the impact of changes in other variables, such as alternative discount rates, the assumed production profile, government take, shares of exports and domestic consumption of oil and gas, population growth, or the growth of the nonhydrocarbon sector.
86. Three reserve scenarios are considered: The low case scenario uses current estimates of proven reserves as of January 2003. The mid- and high case scenarios employ probable and possible reserve estimates according to the U.S. Geological Survey (Table 2).29
|Total oil||Crude||Condens.||NGL||Total gas|
|(in mn tn)||(in mn tn)||(in mn tn)||(in mn tn)||(in bn cm)|
87. Algeria’s hydrocarbon reserves are still considered to be relatively under-explored, and substantial reserve growth can be expected in the future. Therefore, the low case scenario presumably greatly underestimates Algeria’s true hydrocarbon potential. Probable oil reserves are 60 percent and possible oil reserves 145 percent higher than the proven reserves in the low case scenario. For gas, the respective assumed increases compared to the low case are around 27 percent and 65 percent.
88. Three different price scenarios are considered (Table 3). In each case, prices are held constant in real terms throughout the projection period. All prices are in in constant 2003 US dollars. The low case scenario assumes an oil price of $15 per barrel (b) and a gas price of $55 per thousand cubic meters (tcm). These very conservative price assumptions roughly correspond to the minimum prices realized during the past 25 years. The mid case scenario is compatible with the average hydrocarbon prices throughout the 1990s, assuming prices of $20/b for oil and $65/tcm for gas. Finally, the high price scenario is oriented at the long term (1980–2004) price average and sets the oil price at $25/b (which simultaneously represents the mid-price of the OPEC target price range) and the gas price at $85/tcm.
|Alternative scenarios (constant 2003 US$)||Historical prices (nominal)|
|Low Case||Mid Case||High Case||average||average||min||max|
89. After a steep increase since the summer of 2003, the average Algerian oil export price reached $39/b in 2004, a much higher price than assumed in the long-term scenarios. However, the International Energy Agency (IEA) currently projects a long-term real oil price of 25$/b, which is consistent with the high price scenario in the present study.
90. The simulations were based on a specific production profile for total oil and gas for each of the reserve scenarios (Table 4; Figure 5). All profiles assume that hydrocarbon reserves are completely depleted at the end of the projection period in 2050. The development of hydrocarbon production is fairly constrained in the low case scenario, especially the production of oil.
|Total oil (b/d)|
|Total gas (bcm/y)|
|Possible||110.0||180.3||165.6||158.3|Figure 5.Algeria: Assumed Production Profiles for Alternative Reserve Estimates
91. The mid case scenario resembles the current production forecasts of official and independent sources. It allows for a further increase in oil production until 2012, and a steep increase of gas production until 2023. Both the mid case and the high case scenarios are in line with the plans of the Algerian Ministry of Energy and Mining to increase natural gas exports to 85bcm by 2010. While oil reserves are assumed to be depleted by 2040 in the low an mid case scenarios, oil production could be maintained at a fairly elevated level throughout 2050 in the high case scenario.
92. The discount rate for the baseline scenarios is set at 5 percent. Alternative calculations were carried out with interest rates of 4 percent and 6 percent. The population growth rate is assumed to stay constant at the current 1.5 percent, while nonhydrocarbon real GDP growth is assumed at 4 percent throughout the projection period, in line with current staff projections. The simulations presume government hydrocarbon revenues at 63.5 percent of export revenues and domestic hydrocarbon revenues at 12 percent of export revenues. Domestic consumption of oil and gas production is assumed to be constant at 17.5 percent (oil) and 26.5 percent (gas). All shares represent averages realized over recent years.
Main Simulation Results
93. Algeria is endowed with substantial hydrocarbon wealth, which can be best expressed in terms of the net present value of the future government hydrocarbon revenue stream. Assuming the baseline discount rate of 5 percent, the estimates of Algeria’s hydrocarbon wealth (in 2003 US dollars) vary from around $138 billion in the most conservative low reserves and low price scenario to $360 billion in the optimistic high reserves and high price scenario. This translates into per capita hydrocarbon wealth of between $4,331 and $11,342 in 2004. Likewise, hydrocarbon wealth amounts to between 207 and 543 percent of GDP or between 326 and 853 percent of nonhydrocarbon GDP (Table 5).
|Price Scenario||Low Price Scenario||Mid Price Scenario||High Price Scenario|
|in 2003 $||137.8||178.4||222.1||175.1||227.9||284.4||222.7||289.4||360.8|
|in 2003 $ per capita 1/||4,331||5,607||6,982||5,503||7,165||8,940||7,001||9,096||11,342|
|in percent of 2003 GDP||207.4||268.5||334.4||263.6||343.2||428.2||335.3||435.7||543.2|
|in percent of 2003 NHGDP||325.6||421.5||525.0||413.7||538.7||672.2||526.4||683.9||852.7|
Based on 2003 population estimate
Based on 2003 population estimate
94. Algeria’s ample hydrocarbon wealth allows it to permanently run sizable primary nonhydrocarbon deficits. Figure 6 provides estimates of the sustainable PNHB ceilings for the two permanent income-based targets described above. In line with the alternative reserves and price assumptions, nine different scenarios were simulated for each target. As can be expected, results vary widely depending on which assumptions are made. This emphasizes the importance of close monitoring and regular updates of the estimates as conditions develop and new information emerges.
Figure 6.Algeria: Alternative Targets for Sustainable Nonhydrocarbon Primary Deficit
95. All results are shown in percent of nonhydrocarbon GDP (NHGDP), which is considered to be the most relevant fiscal policy indicator of aggregate demand. The sustainable PNHBs gradually decline as absolute wealth (Target 1) or per capita wealth (Target 2) is kept constant, as the population growth rate is assumed to be lower than the nonhydrocarbon sector growth rate. Tables 6 and 7 summarize the results for the alternative price and reserves scenarios. They also show the average sustainable PNHBs for the near term period 2004-09, which are the most relevant fiscal policy indicators for current planning purposes. As a further reference for the evaluation of a prudent fiscal stance in the longer term, the tables also divide the long-term simulations in three more sub periods, showing the respective average sustainable PNHB estimates.
(PNHB in percent of NHGD) 1/
|Low Price Scenario||Mid Price Scenario||High Price Scenario|
|annual change (%)||-3.8||-3.8||-3.8||-3.8||-3.8||-3.8||-3.8||-3.8||-3.8|
In 2003, the actual PNHB amounted to 29.7 percent of NHGDP
In 2003, the actual PNHB amounted to 29.7 percent of NHGDP
(PNHB in percent of NHGDP) 1/
|Low Price Scenario||Mid Price Scenario||High Price Scenario|
|annual change (%)||-2.4||-2.4||-2.4||-2.4||-2.4||-2.4||-2.4||-2.4||-2.4|
In 2003, the actual PNHB amounted to 29.7 percent of NHGDP
In 2003, the actual PNHB amounted to 29.7 percent of NHGDP
96. By construction, target 1 would allow for higher PNHB ceilings than target 2. Taking the mid-case reserves scenario (probable reserves) as a reference for the following discussion, the PNHB ceiling would reach 16.7 percent, 22 percent, or 28.7 percent of NHGDP in 2004, depending on the long-term hydrocarbon price assumptions. Throughout the simulation period, these PNHB ceilings would fall by 3.8 percent annually and be reduced to 2.7 percent, 3.6 percent, or 4.7 percent of NHGDP in 2050, when all hydrocarbon reserves are depleted. Over the entire period, the constant wealth target would allow for an average sustainable PNHB ceiling of 7.8 percent ($15 scenario), 10.3 percent ($20 scenario), or 13.4 percent ($25 scenario), respectively.
97. Keeping wealth constant per capita (target 2) would substantially reduce the initial PNHB ceiling compared to the constant wealth target. Depending on the oil and gas price assumptions, it would reach only 11.7 percent ($15 scenario), 15.4 percent ($20 scenario), or about 20 percent ($25 scenario) of NHGDP, respectively. However, since more income-generating assets are being accumulated over time, the sustainable PNHB ceilings decline only by 2.4 percent annually during the simulation period and would still amount to between 3.8 and 6.6 percent of NHGDP in 2050.
98. Total government spending out of hydrocarbon revenues would be constant in real dollar terms if a policy of real wealth preservation is followed. Per capita spending would decrease continually as the population expands. If government adheres to a policy of keeping real wealth constant per capita, total hydrocarbon spending would increase over time, while spending per capita would be equal over all periods (Figure 7).
Sensitivity of Simulation Results
99. The main part of the analysis considered alternative hydrocarbon reserves and price scenarios. The elasticity of the sustainable PNHB to price changes depends on the originally assumed price level. A one percent change in assumed long-term real hydrocarbon prices changes the sustainable PNHB by 1.15 percent in the low-price scenario, 0.74 percent in the mid-price scenario, and 1.09 percent in the high-price scenario, respectively.
100. However, results may also vary when the assumed values of the other parameters are changed, for example the interest rate, the depletion profile, or the NHGDP growth rate. Consequently, it would be helpful to analyze how sensitive the simulation results react to changes in these parameters.
101. Probably the most interesting case to consider is the effect of changes in the real interest rate on both the value of hydrocarbon wealth and earnings on financial wealth. Other things being equal, lowering the discount rate from 5 to 4 percent increases the net present value of future hydrocarbon revenues. The sustainable PNHB, however, decreases nevertheless, because earnings on accumulated financial wealth are lower. Taking the mid-case reserves and prices scenario as a reference case, the upper PNHB ceiling for 2004 decreases from 22.0 percent to under 20.7 percent in the constant wealth case. Results are more pronounced in the constant wealth per capita case, in which the sustainable PNHB drops from 15.4 percent to 12.9 percent. Of course, sustainable PNHBs would correspondingly increase if a higher discount rate, say 6 percent, is assumed. In constant wealth terms, the PNHB ceilings would rise slightly to 22.8 percent, while it would jump to 17.1 percent in the constant wealth per capita case. The impact of changes in the assumed interest rates can best be described in terms of elasticities: In each year, a one percent increase in the interest rate would increase the sustainable PNHB limit by 0.23 percent in the constant wealth case and by 0.65 percent in the constant wealth per capita case. A correspondent reduction of the interest rate would trim down the PNHB limit by about the same rate.
102. The impact of changes in the other assumed parameter values are as follows (in each case, the mid-price & probable reserves scenario is considered):
- Alternative assumptions about the nonhydrocarbon growth rate leave the net present value of government hydrocarbon revenues unaltered, but they of course change the sustainable PNHBs expressed in NHGDP. The higher the assumed NHGDP growth rate, the lower the respective PNHB ratios, and vice versa. In the short run, the impact on the results of the simulations is rather limited with respect to both targets: A one percent increase in the nonhydrocarbon economy’s growth rate would reduce the average 2004-2009 PNHB limit by only 0.13 percent, irrespective of the wealth target considered. However, as the differences in the growth rate accumulate from year to year, the effect becomes more pronounced over time. It reaches 0.23 percent in 2009, and averages at 0.66 percent over the entire simulation period.
- An increase in the assumed population growth rate would understandably only reduce the PNHB ceiling when a constant wealth per capita is targeted. The size of the effect is also not very strong: A one percent increase in the population growth rate would reduce the sustainable PNHB by 0.43 percent in 2004. This effect would slowly diminish in later years. The average reduction of the PNHB in the period 2004-09 would be 0.39 percent.
- Changes in the government take of hydrocarbon export revenues have a much more pronounced adverse effect on the fiscal sustainability. A one percent reduction in the effective tax rate of hydrocarbon exports would reduce the sustainable PNHB limit by 1.12 percent over all periods. This effect would be even stronger if lower average hydrocarbon prices would be assumed.
- Increasing domestic consumption shares of oil and gas by one percent, thus reducing the volumes available for higher taxed exports would have the same quantitative effect as a reduction in the effective tax rate (elasticity of 1.12).
- Reasonable changes in the assumed production profile would have only modest effects on the sustainable PNHB. Everything else being equal, the faster the hydrocarbon reserves are depleted and converted into interest bearing financial assets, the higher the PNHB ceilings become.
H. Medium-Term Adjustment to Long-Term Sustainability
Previous Fiscal Policy Stance
103. Supported by continually high hydrocarbon prices since 2000, the Algerian government has pursued an expansionary fiscal policy in recent years. An Economic Recovery Program (ERP) was implemented between 2001 and 2004 with the objective to support growth in the absence of a marked pickup in private sector activity, and to provide for economic reconstruction and social needs.30 The PNHB increased from 22 percent of NHGDP in 1999 to almost 30 percent in 2003, and is expected to rise further to about 32 percent of NHGDP in 2004.
104. The expansionary fiscal stance of the past years has contributed to an increase in real GDP and job creation. However, unemployment is still very high (estimated at about 24 percent in 2003), and demand driven gains might turn out to be of a transitory nature.31 Although the existence of infrastructure bottlenecks would justify public investment, the recent surge in capital expenditure from 13 percent of NHGDP in 2001 to 19 percent in 2004 could possibly lead to public investment in projects with low economic profitability. A sustained improvement in Algeria’s growth performance requires an acceleration of productivity-enhancing structural and institutional reforms. Sustainable economic growth and employment creation will be achievable only by developing a strong private nonhydrocarbon sector.
105. The current expansionary fiscal policy carries risks. It transmits hydrocarbon sector windfall revenues into the Algerian economy, thus increasing the role of the state in the economy, possibly leading to a real appreciation of the exchange rate with the effect of a deteriorating competitiveness of the nonhydrocarbon traded goods sector (Dutch disease). Furthermore, fiscal vulnerability to a possible future downturn in hydrocarbon prices increases.
106. At the same time, and under the assumptions made in the above long-term simulations, the recent fiscal stance appears to be unsustainable in the medium term. Depending on the long-term price assumptions, and taking the mid-case reserves scenario as a reference, the government would have to limit the 2004 primary nonhydrocarbon deficit to between about 12 and 20 percent of NHGDP in order to keep total real wealth per capita constant (Table 5). Achieving long-term fiscal sustainability would therefore require a significant fiscal adjustment of the current fiscal stance.
107. The baseline scenarios might be considered overly restrictive in view of actual oil and gas market developments. Taking into account the presently very high hydrocarbon prices and the fairly favorable WEO oil price projections for the medium term—forecasting an only modest decline until 2009—it seems justified to make some amendments to the long-term simulations which would warrant higher limits for the sustainable PNHB.
108. In the following, an illustrative adjustment scenario, based on a modified high price and mid reserves case, will be presented. It is supposed that the government targets to preserve net wealth per capita in the long run.
109. For the years 2004–09, the simulations use current WEO projections for the development of hydrocarbon prices. After that, it is assumed that hydrocarbon prices move smoothly downward and reach the original high case prices ($25 per barrel for oil and $85 per tcm in the case of gas, respectively) in 2013 and stay at that level throughout the remaining simulation period.
110. The consideration of higher hydrocarbon prices in the short- to medium term significantly increase the sustainability limits of the PNHB compared to the baseline case (Figure 8).
Figure 8.Algeria: Constant Wealth per Capita Framework, Scenario Adjusted for WEO Oil Price Projections, Sustainable Primary Nonhydrocarbon Deficits
111. However, a medium-term adjustment of the fiscal policy stance from its current level is needed even when the presently higher hydrocarbon prices are taken into account. The authorities could aim at reducing the PNHB gradually from the current level to a more conservative fiscal stance that would be more in line with the longer term estimates of the sustainable PNHB. Considering that it will not be feasible for fiscal policy to adjust immediately to its long-term sustainable path, the transition scenario also slightly relaxes the original condition of wealth preservation. It is supposed that the government aims at stabilizing wealth at its end-2004 level instead of the originally targeted end-2003 level and plans to reach sustainable NHBP levels within five years, i.e. by 2009 (Figure 9).32
Figure 9.Algeria: Nonhydrocarbon Primary Balance (In percent of NHGDP) Actual and Sustainable Paths under Alternative Price Assumptions Scenarios: Adjustment to Sustainable Path after Five Years
112. Spending now more than is warranted by the wealth preservation condition implies spending somewhat less in future periods. However, the five-year adjustment period is relatively short, and the scenario allows for a long period of catching up to the originally targeted level of wealth, which will be reached only at the end of the simulation timeframe, in 2050. Therefore, the suggested primary nonhydrocarbon deficits are found to be only slightly lower than the originally targeted sustainability limits. Table 8 summarizes the results of the modified scenario and compares the recommended adjustment of the fiscal stance with the long-term sustainable and the actually projected ones.
|Oil Price (in $)||38.5||42.8||38.3||36.0||35.0||34.0|
|HC Revenue (bn DA)||1,569||1,874||1,809||1,877||1,873||1,899|
|gov. HC primary spending (bn DA)||1,148||1,206||1,209||1,188||1,174||1,150|
|gov. HC primary saving (bn DA||421||668||600||689||699||749|
|Implied budgeted oil price ($/b) 2/||31.1||30.3||28.3||25.4||24.6||23.3|
|NHBP (in % of GDP)||19.3||17.8||17.2||15.9||15.0||13.9|
|NHBP (in % of NHGDP)||31.8||30.4||28.2||25.7||23.4||21.2|
|Suggested adjustment path|
|gov. HC primary spending (bn DA)||1,148||1,177||1,182||1,179||1,168||1,149|
|gov. HC primary saving (bn DA)||421||697||627||699||705||749|
|Implied budgeted oil price ($/b) 2/||28.2||29.6||27.7||25.2||24.5||23.2|
|NHPB (in % of GDP)||19.3||17.3||16.9||15.8||14.9||13.9|
|NHPB (in % of NHGDP)||31.8||29.7||27.5||25.4||23.3||21.2|
|Sustainability limits (const. wealth per capita)3/|
|gov. HC primary spending (bn DA)||929||980||1,033||1,089||1,149|
|gov. HC primary saving (bn DA)||945||829||845||784||749|
|Implied budgeted oil price ($/b) 2/||24.0||23.4||22.4||23.0||23.2|
|NHPB (in % of GDP)||15.0||14.7||14.4||14.1||13.8|
|NHPB (in % of NHGDP)||23.4||22.8||22.3||21.8||21.2|
|GDP (in bn DA)||5,939||6,795||7,014||7,464||7,831||8,278|
|NHGDP (in bn DA)||3,614||3,970||4,292||4,633||5,006||5,414|
Excluding the possible additional budgetary impact of the second Economic Recovery Program 2005-08 and quasi-fiscal deficits in the public enterprise sector.
The implied budgeted oil price is derived from the expenditure projected to be spent out of HC revenues.
Scenario: High price (25 $/b, adjusted for WEO price assumptions) and probable reserves; and stabilization of hydrocarbon wealth at end of 2004 level.
Excluding the possible additional budgetary impact of the second Economic Recovery Program 2005-08 and quasi-fiscal deficits in the public enterprise sector.
The implied budgeted oil price is derived from the expenditure projected to be spent out of HC revenues.
Scenario: High price (25 $/b, adjusted for WEO price assumptions) and probable reserves; and stabilization of hydrocarbon wealth at end of 2004 level.
113. The adjustment scenario suggests a significant fiscal adjustment (equivalent to 10.6 percent of NHGDP) compared to the current fiscal stance within a period of five years. This scenario is in fact broadly in line with the current budgetary projections of the Algerian authorities (Table 8). Nevertheless, it is also important to emphasize that the fiscal policy stance recommended here is based on relatively optimistic assumptions about the medium-and long-term development of hydrocarbon prices. Additionally, the scenario does not make any allowances for precautionary savings, the consideration of which is strongly recommended with a view to the significant uncertainties about future developments about prices and reserves.
I. Summary and Concluding Remarks
114. Algeria is well endowed with hydrocarbon wealth, which - if well managed - allows the country to run sizable non-hydrocarbon deficits that can be used to finance economic development, structural change and to reduce unemployment. It can be expected that the Algerian hydrocarbon industry will continue to grow dynamically and remain a major source of government revenue in the decades to come.
115. However, as other oil and gas producing countries, Algeria faces several macroeconomic policy challenges both in the short and long term with respect to the management of its natural resource wealth. In a short- to medium term perspective, fiscal policy has to deal with high volatility of hydrocarbon revenues, as well as with the impact of substantial foreign exchange inflows in the context of limited absorptive capacity of the domestic economy. In the long term, policymakers have to consider the exhaustibility of hydrocarbon resources with important implications for fiscal sustainability and the distribution of hydrocarbon wealth across generations. Equally important, the Algerian authorities face the challenge how to best use the country’s hydrocarbon wealth to tackle the daunting tasks of attaining higher growth and reducing unemployment.
116. In the past, Algeria has not at all times been successful in managing these policy challenges. Fiscal policy has often been excessively expansionary and public expenditures highly correlated with hydrocarbon revenues, thus increasing economic uncertainty, causing high adjustment costs for frequent factor reallocation, and damaging nonhydrocarbon private sector development. At the same time, the public sector has not always been able to use hydrocarbon income productively in the form of revenue- as well as employment creating and growth enhancing investments.
117. This paper aims to provide some guidelines for the efficient fiscal management of hydrocarbon wealth in Algeria. It presents strategies and policy instruments to tackle the macroeconomic policy challenges discussed above which would enable the country to reap the potential benefits of its natural resource wealth. Specifically, the paper suggests:
- Preserving government net wealth and distributing it equally across generations by saving part of hydrocarbon revenues in the form of financial assets;
- Introducing a permanent income hypothesis (PIH) based fiscal framework for ensuring long-run fiscal sustainability, with the nonhydrocarbon primary deficit being the main fiscal policy variable;33
- Gradually adjusting the fiscal stance, especially expenditure, to a sustainable level according to the appropriate wealth target chosen by the authorities;
- Stabilizing expenditures a PNHB level considered as sustainable, and decoupling public spending from current hydrocarbon revenue to avoid transmission of hydrocarbon sector volatility into other sectors of the economy and vulnerability to hydrocarbon price fluctuations over the medium term;
- Spending judiciously to create jobs and raise nonhydrocarbon growth; and
- Sterilizing large foreign exchange inflows by investing hydrocarbon receipts in financial assets abroad.
118. Fiscal guidelines as those discussed above can be constructive policy instruments for the efficient fiscal management of hydrocarbon revenues. Properly designed and implemented, they can aid policymakers avoiding unsteadiness of the fiscal policy stance in the presence of volatile hydrocarbon prices. Regarding fiscal sustainability and intergenerational equity considerations, fiscal guidelines such as the permanent income-based nonhydrocarbon primary deficit framework can serve as useful guiding principles for medium- to long-term budget planning.
119. However, the formulation of fiscal guidelines does not by itself imply a credible fiscal policy (Kopits 2001). Fiscal guidelines by themselves cannot prevent the destabilizing and unsustainable policy choices that are so regularly taken during hydrocarbon booms with potentially huge windfall revenues (Bjerkholt 2002). The sudden availability of unanticipated financial resources makes additional spending tempting, and increasing pressure from diverse political interest groups easily leads to reluctant adherence to or to a softening or even complete abolition of the rules-based fiscal frameworks.
120. The main objective of preannounced, formal, and legislated fiscal frameworks is to increase the credibility of fiscal policy by constraining the scope of action of policymakers and increasing public awareness if deviations from prudent fiscal policies should arise (Kopits and Symansky 1998). It is crucial that the implementation of fiscal guidelines will be backed by firm political support and public scrutiny, and that they be complemented by sanctions and supporting measures to increase transparency and accountability of fiscal policy. If this is not the case, the introduction of rules-based fiscal frameworks can actually do more harm than good, for example by encouraging the use of creative accounting (Milesi-Ferretti 2000), the resort to off-budget expenditure programs and transparency-reducing legal loopholes, or to paradoxical situations such as the accumulation of revenues in hydrocarbon funds with simultaneous borrowing for expenditure programs (Clemente, Faris and Puente 2002).
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